06 Feb

$100bn is Right if Facebook is the New TV

Facebook’s stats are amazing:

  • A huge and loyal customer base: 845m users, of which a whopping 483m are daily active users (DAU).
  • Dream margins of 75-80%.
  • Cash reserves of $3.9bn, with the IPO come $5bn more.

But is Facebook worth $100bn? This means 17x 2012 sales and a P/E ratio of 60. Google’s current Price/ Sales is 5 and P/E is 20.

Discussing Facebook’s valuation, many internet pundits have quoted and retweeted a blog post by Silicon Valley VC Bill Gurley . Gurley’s excellent blog post lists several reasons why Facebook should be valued in the $70 to 100bn range. Regarding the much-cited threat of Google+, Gurley, who knows a thing or two about internet platforms, says that it is very, very hard to leave Facebook. Nobody likes to leave their friends behind.

In a recent CNBC show, Facebook was called a “beast.” The journalists went on to say that Facebook is “not a dotcom” but instead a “real company.” Nice statement, considering that Mark Zuckerberg’s Letter to Shareholders in the Facebook SEC filing begins with the words: “Facebook was not originally created to be a company.”

Facebook certainly isn’t a normal company and this is not your average IPO.

Thank you Wikimedia, Creative Commons Licence, for file reuse.

But if Facebook is to be valued at $100bn, it needs to grow. And growth does not mean number of fans, but paying advertising customers. In 2011, Facebook grew by a stunning 88%. But in Q4 2011, the company grew only by 55%. In it’s February 1 SEC filing, Facebook itself states that an 88% growth rate is not sustainable.

The global advertising market is an established industry. There are only two ways to grow: (1) Take revenue away from other competitors currently generating ad revenues, or (2) grow the advertising market as a whole.

The global advertising market is huge: $464bn in 2011 (all figures from Zenith Optimedia). However, the market itself does not grow significantly (+3.5% last year). And Google will soon make up almost 10% of the global ad market. Google already accounts for 44% of total internet-based advertising. Can the ad market sustain another rapidly growing internet gorilla? If Facebook starts to eat into Google sales, this would be detrimental for both companies; there would be little headroom for Facebook and it would be a savage and expensive competitive fight.

Offline to online substitution is the key. While Google sales grew by $9bn in 2011 alone (from $29bn in 2010 to $38bn in 2011), newspaper ad revenues were in constant decline in past years (dropping from $95bn to $91bn). Mind that we are comparing a single company to the whole newspaper industry. Of course, Google is not alone responsible for the decline of newspaper revenues, but there certainly was a competitive shift taking place with revenues moving from offline to online.

Facebook has a lot of potential to convert offline ad sales into its own revenues, too. Facebook ads have better branding power than search ads, so it may even have an advantage to Google. Facebook’s attack trajectory is against TV. With revenues of $184bn (2011), TV is much bigger than newspaper publishing. There is enough headroom for Facebook here for the next couple of years.

Can Facebook pull off being the new TV, at least in terms of attractiveness to advertisers? TV is the domain of large advertisers, such as Coca Cola. Coca Cola’s ad budget in 2010, for example, was $2.9bn.

A shift will not happen overnight, and television is a beneficiary of massive events, like this year’s Olympics in London. Facebook will certainly do all it can to persuade large advertisers to shift part of their ad spend. Getting large advertisers on board is the Number 1 challenge Facebook will face in coming months.

It is possible, however, that Facebook has the power to grow the whole ad industry. I hate to use the Groupon example, because the company has in my opinion been poorly understood. But Groupon uncovered a new hyperlocal demand for advertising among small, mostly service-based companies, which had been improperly addressed by conventional advertising offerings. There is no other way to explain Groupon’s massive growth in such a short amount of time.

Facebook has this potential to uncover new demand, too, but in many more ways than Groupon. Facebook is a top mobile application. Facebook’s mobile apps do not show ads now, but that is being changed as you read this blog post. Facebook ads can be hyperlocal (restaurant in your part of town), hypertimely (there is a sale near where you are right now) and hypertargeted (new book by your favorite obscure Brazilian author).

Facebook will generate new sources of ad revenues from millions of small companies who have never relied on advertising before.

The only limit to Facebook’s ability to generate advertising revenue growth is Facebook itself. The trick about advertising- offline and online – is not to overdo it. In the book SimplySeven I co-authored, we describe the downfall of MySpace, at one point in time much larger than Facebook. The quantity and quality of advertising always needs to be delicately balanced and MySpace simply overdid it, going for short-term cash instead of user satisfaction.

Facebook clearly recognizes the danger of ad overload, however. To quote again from Mark Zuckerberg’s letter in the SEC filing: “Simply put: we don’t build services to make money; we make money to build better services… These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits.”

Facebook will continue to grow if it executes well. Smaller advertisers will discover and use Facebook for hyperlocal, hypertimely and hypertargeted ads, even through they did not advertise much before. The bigger challenge probably are the large ad accounts, which embrace the branding power and emotional quality of television.

There may be a third source for revenue growth, however, beyond advertising. In a previous blog post, I described how the internet flagship companies eBay, Google and Amazon already generate US$1bn each with complementary business models – on top of its original business. Already today, Facebook derives more than half a billion (15%) of sales from non-advertising sources, the bulk of this probably from Zynga. Zynga sells virtual goods in its games, providing Facebook with a commission (it also buys advertising directly on Facebook). There is more. Imagine if Facebook would offer premium subscriptions to its 845m members. Or if it offered its own (cash-) payments system like PayPal? At the moment, Facebook is still focusing on its primary revenue model advertising and the challenge of winning over large accounts, but the potential for growth on top of advertising itself certainly is there.

09 Jan

Stress-Testing the Simply Seven

Time for a stress test

The Simply Seven framework of seven business models emerged out of our practical work with internet businesses since the mid 1990s. After agreeing on an initial framework in a moderated series of discussions, we used the approach in our daily work for several months. Our understanding had slightly evolved, but not that much. We were happily surprised by the resilience of the approach. Now was the time to put the Simply Seven through a numbers-based stress test.

It took some effort to arrive at a representative group of significant internet companies. A combination of the Nielsen Global Top 100 with additional selection criteria finally did the trick. As shown below, we were able to generate a rich cache of data for the more popular internet business models. The fact that there was less data on some of the others, however, indicates that the internet economy has not reached maturity yet.

Our main objective for the stress test was to see if we were right in our assumption that there are exactly seven business models. No more, no less. We also wanted to check how the different internet models compare to each other using some basic financial indicators.

The selection criteria

To arrive at a consistent set of comparable information, we selected the companies for our so-called “internet universe” according to three different parameters:

(1) The company has to be present with its internet presence on the January 2010 list of Nielsen Top 100 Global Websites (See: http://news.bbc.co.uk/2/hi/8562801.stm). We chose the Nielsen Top 100 list to arrive at a group of significant internet companies in a non-arbitrary way. We figured, if you are a global internet leader, you are on that list. One problem with using this list is that it is prejudiced against B2B companies, including some prominent ones, such as Salesforce.com. B2B companies simply do not attract as many users to their web sites, compared to consumer businesses. While it is much harder for a B2B company to make the list, nevertheless, some are included. These companies have a significant base of small and medium-sized businesses as clients. Examples are both of our service sales representatives, Experian and Vistaprint. Experian provides credit information, Vistaprint a printing service.

(2) The company has to be listed on a stock market. The reason for this is simple: We need reliable financial information. Specific company financial information used came from the Annual Reports of these companies. Basic financial information (Enterprise Value, CAGR, Sales, Operating Income) came courtesy of Yahoo! Finance (finance.yahoo.com, sourced from Capital IQ and other information providers such as CSI Commodity service or Morningstar) and Etrade (www.etrade.com).

(3) The company has to generate approximately 50% of its revenues through internet business. This is tricky, but absolutely necessary. While a company that has a strong web site and generates some of its sales on the internet is, of course, employing an internet business model, its financial profile will reflect the whole business (unless the internet part is separately identified in its financial reports, which is seldom the case). Comcast is on the Nielsen Top 100 list because it has a popular web presence, but it is mostly a cable TV and telecommunications company. The same applies to Time Warner. Netflix just barely made the list of internet companies. It is included because it has successfully transformed a significant proportion of its subscription business in recent years from a postal-based DVD rental offering to a streaming-based internet service. Netflix’ Annual Report mentions that 48% of its 12m subscribers watched streaming video over the internet in Q4 2009 (2009 Netflix Annual Report and Proxy Statement, p. 1, 27).

Initial results: Seven confirmed

We were left with 21 companies in our universe, which were on the Nielsen Top 100, were listed on a stock exchange somewhere in the world and generated around 50% or more of their sales over the internet. We cheered when we found out that each of our seven internet business models was present with at least one company. We also could not identify an eighth business model. Nor was a model redundant.

There were big differences, however, to what extent the different business models were represented. The advertising and commissions categories were the strongest with eight and four companies represented respectively. Here, we could carry out some pretty solid analysis. Subscriptions, service sales and retail were OK, with three to two companies each.

The listing of the first pure play internet company, the Netscape IPO, happened over 15 years ago. Since then, thousands of internet companies have been founded and several dozens of internet companies have listed, each of them generating a long trail of financial information. One would expect that every business model would be represented several times on the Top 100 list and also be listed on a stock exchange. Not so.

The weakest categories each had only one representative company. They were unsurprisingly, financial risk management, and, surprisingly, digital license sales. The only financial risk management candidate, IG Group, is a strange creature, part foreign exchange spread betting service, part sports betting.

Apple is the 1,000-Pound gorilla of the digital license sales business model at the moment – but it hardly is an internet company. We would have loved to have seen this innovative company included in the financial analysis, but Apple still makes far more than 50% of its revenues off hardware and devices. The company we were left with, Real Networks, had dismal financial results in 2009 and 2008. Just one company in the digital license sales category and that one loss-making on top of it; this does not really give us much to base our comparative analysis on.

We expect many more internet businesses working with the models license sales or financial risk management to enter our universe of significant companies in the next months and years. We are not there yet.

A note on Dell. While Apple was grudgingly removed from our universe of internet companies, we did include Dell. Dell is known for being the classic direct sales company – without a bricks-based retail presence (although Dell very recently has begun to enter the classic retail channel, especially in emerging economies). Unfortunately, there is no confirmed information from Dell about the proportion of direct internet and phone sales compared to indirect retail channel sales. Also, we know that 54% of Dell’s total worldwide sales in 2009 was to large enterprises and to the public sector; in these cases, the internet is used to support the order process, but not facilitate the business model. The remaining 46%, however, is almost evenly divided between small- and medium-sized companies and consumers. In the end, it was a very close call. We decided to include Dell in our universe of internet companies. It is a listed company, of course, and also is present on the Nielsen Top 100 List.

Our 21 companies

Grouping into one of the Seven

Most of the 21 companies were a no-brainer to group into one of the Simply Seven categories. Google is a thoroughbred advertising company – at the moment, at least. The year 2010 was great for Google’s mobile operating system Android and with it comes Android Marketplace, a digital license sales platform. And Google is making progress selling its office software as software-as-a-service subscriptions to companies. So far, however, a vast majority of Google sales still come from the advertising model.

We had to look up the revenues of some companies. As mentioned, Netflix just scraped by into our universe with its expanding online user base. Reed Elsevier actually is a long established company – several constituent parts of which long predate the World Wide Web. But two of its main businesses, LexisNexis (42% of revenues in 2009) and Elsevier (33%) are classic subscription models (Reed Elsevier, 2009 Annual Report and Financial Statements, page 11). LexisNexis, the legal database, is completely online and Elsevier, die academic publishing arm for scientific and health journals, almost entirely so.

AOL used to be the best-known company around for the subscription model. In 2006, AOL generated 75% of its sales from longer-term contracts as an online service provider. The degree of competition in the ISP (internet service provider) space was so tough in recent years that AOL was forced to become an advertising-based company. 56% of revenues were generated from advertising in 2009. The sad part of the story is that the switch of business models was not achieved by a strategic transformation but by sheer financial erosion of subscription sales. In 2009, AOL generated roughly the same sales from advertising as in 2006, but only a fourth of its subscription revenues (AOL Inc. Annual Report 10-K, 02.03.10, page 35).

Amazon historically is one of our most active companies when it comes to testing different business models. For now, at least, Amazon stays retail. Amazon.com’s initiatives with digital license sales (downloads for the Kindle reader and sale of music and video downloads) and commissions (third party marketplaces) are still developing. Amazon is moving into license sales and commissions to decrease its reliance just a little on its costly real world warehouse and shipments business. Amazon shares the retail group with Dell, incidentally.

From a classic bricks and mortar perspective, Dell and Amazon do not have the same business model. With a few exceptions, Amazon sells stuff created by other companies; Dell sells its own stuff. Amazon is a retail company; Dell is IT.

For the purposes of our business model framework, both companies belong to the same group. The customers of both companies go to their respective web sites to buy physical items, which are subsequently shipped to them. Amazon and Dell face many of the same challenges; they operate an online storefront, they manage shipments and returns. Whether one company makes its own stuff or not, is not relevant for our framework since it does not change what the customer is getting for her money (a physical product). In fact, Amazon has started to introduce its own range of products, called AmazonBasics.

Indie bands selling their own music directly over the internet and an aggregator such as Apple also share the same digital license sales business model, while in real life they are perceived as running very different businesses.

Our business model framework was created with a single perspective in mind – the customer perspective. And with a single question: What exactly is the customer buying? The customer perspective makes things very simple.

Of course, the customer will be very interested in the ease of use of the shop and the quality of the service. And she will need to find the shop in the first place and the product she seeks. Amazon or Dell may have different advantages and disadvantages in providing these services – based on the fact that they are a retailer or a direct brand owner and manufacturer.

In a way, we were very fortunate that the internet flagship companies, such as Google, eBay or Amazon, still generate most of their sales with a single internet business model. We are not sure how this will pan out in the future. Google may very well continue to be successful with its Android Marketplace – which is based on a digital license sales model. Amazon is moving more and more into this direction as well, with digital books and music. The most likely outcome is the following: Some significant pure play companies will successfully stick to a single business model. There will be others, however, which increasingly mix the models.

At the moment, however, we can still compare basic financial information of our internet universe companies to each other and get a good indication of the performance of particular business models.

The Retail business model clearly leads in sales

The inclusion of a large IT manufacturer in the category of internet retail does mean that the total amount of revenue generated in this category is high. Retail clearly leads the pack in the amount of revenue generated by each category and the amount of monthly revenue per unique user. Dell and Amazon also lead the Top Five list of companies in our universe with the highest revenue in 2009.

It is easy for Dell to lead the list of sales generated per unique internet user. Dell has the highest revenue of all our companies ($52bn) but has relatively few unique users (23m per month). Compared to other companies in the Nielsen Global 100, it is on rank 57 for the number of unique website users. Obviously, the users that Dell has on its web site are there to buy computers and accessories, which are pricy ticket items. Also, as discussed earlier, a 54% of Dell’s revenues are generated through large enterprises and the public sector. To arrive at our statistic, we divide the average monthly sales in 2009 by the number of unique monthly users determined by Nielsen in January 2010.

While advertising dominates the other lists, that there are no advertising-based companies on the top five list for revenue per unique web site user. Obviously, this is because advertising has a small value contribution per unique web site user compared to all other business models. The client of the advertising business is not the web site user itself but a business; the web site user is not buying anything at all. Google leads the pack with $5.64 monthly revenue per monthly unique user; the average for all advertising internet companies (per company) is $2.14.

Many users and rapid growth – the advertising business model

Advertising is about reaching the highest numbers of people. It also is about the quality of those people, if they are in the right target group or not. As a general rule of thumb, however, the more the better. And advertising also is the most popular business model in our internet company universe. This explains the massive lead the advertising business model has before all others in the amount of monthly unique users. Next to the mega gorilla Google, there are some other 1,000-pound specimens in this group, such as Yahoo!, AOL and Monster.com.

The advertising business model does not just benefit the company offering advertising as a product to its business clients itself, but also many other popular publisher web sites which use advertising as their revenue stream. Jointly with commissions, the advertising business model is very good at integrating different types of internet companies in a business ecosystem.

The success story of Google in the time period we are examining is without parallel. Google generates $1.0m sales per employee – the highest of all companies in our universe. It grew a whopping 40% annually each year from 2005 to 2009, a spectacular record in itself. Google’s growth is even more impressive given the fact that the global internet, according to the web site Internet World Stats, grew a mere 15% in the same period year on year (from 1.018bn in December 2005 to 1.802bn in December 2009) (Internet World Stats: www.internetworldstats.com).

All other Top 5 CAGR companies are miniscule in terms of their sales compared to Google. It is no surprise then, that this is recognized by the stock market. Google also clearly leads the list Enterprise Valuation over Sales.

Market valuations – Advertising, again

We already discussed why Google is the hero of our internet company universe. It is surprising, however, that two other advertising-based enterprises make the top EV/R list. Is this only because the stock market is deluded by advertising and Web 2.0 hype? We don’t think so. WebMD and Monster are companies that do not only reach significant amounts of people, they are specialized players with a clear profile: Job search and health. Both of these are huge real world markets. As more business goes digital in these segments, these companies will benefit.

We have removed IG Group from the EV/R consideration because its EV/R ratio (500x) was distorted due to small trading volume and a significant cash pile the company has collected relative to its sales.

Margins – The beauty of aggregation

Advertising- and commission-based companies lead the list for the highest margins. This is because, as classic aggregator-type, purely digital businesses, they tend to have far lower cost bases than most others.

Other businesses models cannot compare to these two in terms of margins. Retail companies have to deal with shipment and warehousing costs. Amazon’s operating income margin in 2009 was only 5%. Subscription-based companies usually have higher customer service costs and often need to provide a continuous stream of value to their customers to justify the subscription contract. In terms of their margins, they linger in the middle of the pack. Netflix, which runs a very tight ship, achieved a margin of 11% in 2009. Reed Elsevier generated a margin of 13%.

Service companies sell unique products or services, which also can be quite costly unless you have scalability worked out. We have two services companies in our universe. Vistaprint provides a printing service. Experian offers credit information. Both services can be automated to a high degree, resulting in margins that are not altogether bad. Vistaprint’s operating income margin is 12%. Experian’s is 16%.

There is an exception on the top, however. It is an indication of things to come, that our only financial risk management company, IG Group, leads the margins list. By offering foreign exchange spread betting and sports betting, IG Group is able to generate dream margins. We are sure that the financial model will become more attractive with growing liquidity on the internet.

Summary – Key financial indicators

To conclude the analysis of the universe of internet companies, we created a bubble chart showing three important financial valuation parameters: Total sales, margins and growth.

We picked out the two top companies in the EV/R ranking for each business model, for financial risk management and license sales we had only one company each. These companies are regarded by investors as the best in their class.

The summary chart shows that the selected companies vary strongly regarding to the growth they achieved in the last years. This was to be expected.

The summary chart also confirms yet again the heroic position of Google, which gets everything right: Sales, growth and margins. IG Group, the lone representative of financial risk management is up there, too, albeit with a far smaller revenue base than Google and therefore much less impressive in terms of sheer achievement.

What is interesting overall is that there seems to be some correlation among the business models based on margins. The highest operating income margins are achieved by financial risk management, advertising and commissions, followed by services and license sales. subscriptions and retail are at the bottom. The margin of WebMD disappointed as an advertising company. We were surprised by how well the services companies did and by the lackluster performance of subscription. Obviously, with just 21 companies, we have to tread carefully. The analysis of basic financial information was carried out to complement and stress-test our practical observations of the Simply Seven.

Note: The authors would like to thank Michael Heim for creating the Simply Seven universe of internet companies and for the number crunching.