Technology (Alpha) Facebook: Too Early to Tell. Krause Fund Research Spring Facebook, Inc. (NASDAQ: FB)

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1 Krause Fund Research Spring 2016 Technology (Alpha) Facebook, Inc. (NASDAQ: FB) Current Price: $ Target Price: $60.92 Analysts Jacob Molina Mingjian Li Recommendation: NO ACTION Facebook: Too Early to Tell April 19, 2016 Company Overview Facebook, Inc. (NASDAQ: FB) builds useful and engaging products that enable people to connect and share through mobile devices and personal computers. They also help people discover and learn about what is going on in the world around them, enable people to share their opinions, ideas, photos and videos, and other activities with audiences ranging from their closest friends to the public at large, and stay connected everywhere by accessing their products, including Facebook, Instagram, Messenger, WhatsApp, and Oculus. Stock Performance Highlights 52 week High $ week Low $72.00 Beta Value Average Daily Volume m Share Highlights Market Capitalization $ b Shares Outstanding 2.83 b Book Value per share $15.60 EPS 2015 $1.31 P/E Ratio ttm Dividend Yield N/A Dividend Payout Ratio N/A Company Performance Highlights ROA 7.46% ROE 8.34% Total Revenues $12.47 b Financial Ratios Current Ratio Quick Ratio Debt to Equity 10.50% Profit Margin Ratio 20.57% Gross Margin Ratio 84.01% Facebook has the largest user base among all social media companies. On average, 8 out of 10 American adults use Facebook every month. A leading position helps Facebook gain more investments and generate revenues from companies looking to advertise than any other social media company. Social media is a new and highly competitive industry and Facebook is facing challenges from other new social media companies. For example, younger people tend to use Snapchat more often than Facebook, which takes away users from Facebook s user base. If Facebook cannot launch new, innovative products to attract younger users, Facebook will lose potential future revenues. Facebook has seen 30% growth for its revenue and net income since Companies have been beginning to utilize social media networks as a tool to do advertise on. Facebook has benefitted from this and, as a result, in spring 2016, the stock price of Facebook beat the expectations and increased by 15%. However, high returns mean high risks. No companies can maintain a 10 % growth rate forever, let alone 30%. The total potential user base within the US has become saturated. We are not sure whether Facebook can experience huge growth outside of the US. If they do not meet the expectations of their stockholders, their stock price will decrease. One Year Stock Performance Source: Yahoo! Finance (Blue = FB, Red = S&P 500) Important disclaimer appears on the last page of this report 1

2 EXECUTIVE SUMMARY We do not recommend investing in Facebook because we believe that once Facebook transitions from its growth phase to its maturity phase, the stock price will start to decrease due to the company not being able to meet stockholders expectations of growth rates and overall levels of net income. Although Facebook has seen tremendous growth over the past few years in terms of its user base, revenues, and net income, we believe it is unreasonable to assume that Facebook will be able to maintain these levels for more than a few years Users of Facebook (In millions) E The users of Facebook (In millions) E Linear (The users of Facebook (In millions)) 2018 E Source: Bloomberg Business (Updated 2/26/16) Unemployment Rate The U.S. national unemployment rate is calculated by The Bureau of Labor Statistics (BLS) and is done by surveying 60,000 households across the country. After data is collected from this sample population, the unemployment rate is calculated by dividing the number of people who are gainfully employed by the number of people who are out of a job, but who are actively looking. People who claim to be out of a job and not actively looking are not accounted for in the calculation of the national unemployment rate. Source: Facebook 10k ECONOMIC OUTLOOK Real Gross Domestic Product (GDP) The real gross domestic product is the inflation adjusted value of all goods and services produced within our economy during a given time period. GDP is often used as an economic indicator for the overall health of the economy. One method of calculating GDP is by using the expenditure method which is calculated by the sum of four main factors which are: private consumption, private investment, government spending, and net exports. Since a large portion of GDP is calculated based upon private investments and consumption, GDP can be related to other economic factors such as Consumer Confidence Interval (CCI) and Unemployment Rate. Future growth rates of GDP can help us to predict the growth in Facebook s revenues numbers. With a 1.4% growth of real GDP in the fourth quarter of 2015 and a forecasted growth of GDP being between 2% and 3% in the coming years, we can predict that Facebook s sales, in the U.S. will also increase. This relationship can be derived from the increased consumer spending and confidence in the economy. The following chart shows the change in U.S. real GDP in the last ten years. Historically, you can see that real GDP growth remains between 2% and 3%, except during a recession such as in Consumer confidence is inversely related to the national unemployment rate because when consumers see an increasing unemployment rate, they fear a potential economic turmoil may be near. The current unemployment rate in the U.S. is 5% and as you can see from the chart below, the unemployment rate has been steadily decreasing for the past five years. This is important to Facebook, because as more consumers are employed the amount of disposable income consumers are willing to spend on products such as Facebook s new virtual reality headset, the Oculus Rift. Source: Bloomberg Business Inflation Rate The inflation rate in the U.S. is calculated by tracking the changes in the Consumer Price Index (CPI). CPI and Producer Price Index (PPI) are closely related to one another. For example, PPI in the technology sector has been steadily decreasing since 1990 due to what we believe are improved Important disclaimer appears on the last page of this report 2

3 technologies for producing IT hardware. This idea is related to Moore s Law which states that the number of transistors on a circuit double roughly every two years and because of this keep technology costs down. Due to the decrease in PPI, the CPI in the technology sector has also been decreasing because of decreased production costs and an increased supply of hardware and software in the market. Within the last five years, the overall inflation rate has been pretty low, in between 0% and 2% with it being less than 1% the last three. This trend is illustrated in the graph below. Consumer Confidence Interval (CCI) The Consumer Confidence Interval (CCI) is a measure of consumer s optimism on the health of the economy. A high CCI means that consumers are very optimistic about the current and potential future of the economy, which has the potential to lead to increased spending of discretionary income in the economy. As you can see from the graph below, CCI has been on the rise for the past five years. We believe that when there is a higher CCI, companies in the Technology sector will be more profitable due to increased disposable income for consumers to spend their money on products. In addition, with personal income levels increasing around an annual rate of 0.4% we can expect all sector to benefit due to increased money for consumers to use at their discretion. In the future, we predict CCI to continue to increase at a constant rate of around 2% over the next couple of years. Source: usinflationratecalculator.com Foreign Exchange Rates The foreign exchange rate represents the value of one currency against that of another. The value of the US dollar is crucial to many countries and international companies. Companies, like Facebook, that operate overseas have to keep a close eye on the exchange rates to avoid losses in their profits. The US Dollar Index compares the US Dollar to a basket of six other currencies. The US Dollar Index started at 100 basis points in 1970 and anything below that would imply that the value of the dollar has decreased. This index is currently juts below 95 which means the dollar is still relatively pretty strong as it has only decreased roughly 5% in forty years. Below is the historical chart for the US Dollar Index which shows a fairly strong dollar for the past two years. Source: tradingeconomics.com INTERNET SOFTWARE & SERVICES INDUSTRY ANALYSIS Industry Description Facebook operates within the Technology sector of the overall economy but more specifically, the Internet Software & Services Industry, which contains companies that provide Internet services, including personal and business access to the Internet. The current product lines for the Internet Software & Services Industry include online searching, social media, online communication, and mobile apps. The main companies for this industry include Alphabet (Google), Facebook, Yahoo!, and others. Source: Bloomberg Business Important disclaimer appears on the last page of this report 3

4 Industry Market Sales (in Millions) revenues, and subscriber revenues, but they are very marginal compared to advertising revenues. New initiatives within the Internet Software & Services include pushes for mobile advertising, as it is becoming one of the most important sources of revenues for companies as mobile apps continue to increase in popularity and more and more people gain access to smartphones. Number of Smartphone Users Worldwide (in Millions) Source: 10K Alphabet Facebook Yahoo Microsoft Twitter LinkedIn ebay Other The business segments within the Internet Software & Services Industry include advertising, searching, and social media. We believe that mobile advertising will likely grow and overtake search as the largest category of online revenues within the industry as we continue to see growth in the number of people using mobile apps E 2017E 2018E 2019E Users In terms of revenue streams, advertising continues to be the most important source of revenue for companies within the Internet Software & Services Industry. For example, digital advertising currently contributes over 89% of Alphabet's revenues, over 92% of Facebook's revenues, and 81% of Yahoo!'s revenues (Kessler). 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Make Up of Industry Leaders' Revenues Facebook Alphabet Yahoo! Source: Statista We also believe that companies within the industry will begin to look overseas to expand their business due to oversaturation in the US Market and Asian markets beginning to ripen with opportunities for expansion. For example, we believe that the Chinese government will eventually lift its bans on companies like Facebook and Alphabet and allow them to operate within its market and expand their user bases. Recent Developments and Industry Trends Companies within the Internet Software & Services Industry are starting to move towards mobile advertising as it has been making up more and more of total Internet advertising revenues over time. Advertising Revenue % 6% 3% 2% 4% 39% Advertising Other Revenue 17% Source: 10 k However, we believe that the growth rate in advertising revenue for the companies within this industry will decrease over time due to increasing competition within the market and the inevitable decrease in growth rates as companies' revenues continue to increase. Other sources of revenue for companies within this industry can include license revenues, service 23% Search Mobile Formats Banner Digital Video Classifieds Rich Media Sponsorship Other Important disclaimer appears on the last page of this report 4

5 Source: IAB Internet Advertising Revenue Report Last year, mobile advertising made up a third of Internet advertising revenues for companies within the industry (Kessler) and we believe that this number will only continue to grow as mobile apps have been becoming more popular with consumers and access to smartphones has been increasing around the world. Companies within the Internet Software & Services Industry have increasingly been buying back shares and have participating in more merging & acquisitions in the past few years. We believe that these companies will continue to invest in their own shares since their shares are becoming more and more valuable and will also continue to participate in mergers & acquisitions as it is a way to literally buy up competition and give their company a competitive advantage Source: NetAdvantage Advertising Revenue % 1% 4% 5% 7% 14% 30% 37% Search Mobile Formats Banner Digital Video Classifieds Rich Media Sponsorship Other Return on Internet Software & Services Industry and S&P S&P 500 Internet Software & Services Recently passed Net Neutrality Laws will more than likely enable and support continued innovation and competition within the industry (Kessler). Net Neutrality is intended to level the playing field within the industry and offer the same opportunities to start-up companies and larger companies. One expected outcome of Net Neutrality Laws are that advertising prices will increase, which will be a disadvantage for smaller advertising companies (Cordray). We are unsure as to whether or not the law will have its desired effects because, in terms of technology, people tend to stick to what they are familiar and comfortable with rather than branch out and try something completely knew. So only time will tell. Some companies within the industry, such as Google and Facebook, are trying to expand into markets overseas, especially in Asian markets. We believe this strategy will help those companies increase revenue and net income more since the market of North America, the primary market of the industry, is already saturated. For example, the increasing numbers of Facebook users in North America is 13 million while the increasing numbers of users in Asia is 90 million Source: 10k In addition, the CEO of different companies have expressed how important the Asian market is to them. For example, recently the chairman for Alphabet came out and said that they have plans to expand back into China and that the company has been in constant contact with Chinese companies and officials, which will help to make these plans a reality (BBC). We believe that we will see a continued increase in users in Asia since the market in the US has become so saturated with Internet Software & Services companies. Important disclaimer appears on the last page of this report Monthly Active Users in US & Canada (in Millions) Monthly Active Users in US & Canada Linear (Monthly Active Users in US & Canada) Monthly Active Users in Asia (in Millions) Monthly Active Users in Asia (in Millions) Linear (Monthly Active Users in Asia (in Millions))

6 Markets and Competition The current competitive climate for the Internet Software & Services Industry is seen as one of the world's most dynamic and competitive environments (Kessler). Within the industry, it can be observed that the larger companies often dominate certain key areas with Alphabet dominating the Searching business segment and Facebook dominating the Social Media business segment (Kessler). These larger companies dominate these business segments because they start business early so that their brand is more widely recognized within the segment, their user bases are larger, they control a captive audience, they have a more diversified and successful business model, and also have greater financial flexibility to implement many different strategies due to large amounts of market capital. The major players within the Internet Software & Services Industry are Alphabet and Facebook who make up 83.5% of the entire industry's total revenue. and become very popular amongst teenagers and as a result, their user base has been continously growing. Facebook Twitter Instagram Snapchat Demographic of User Bases for Top Social Media Companies (in Years of Age) 0% 20% 40% 60% 80% 100% Industry Market Sales (in Millions) Source: Business Insider If other companies have similar success like Snapchat and attract other users, Facebook could face challenges in retaining its current user base. In terms of consumers, Facebook has over 1.6 billion users in its user base and has been seen continuous growth since Source: 10K Alphabet Facebook Yahoo! Microsoft Twitter LinkedIn Other The competitive forces that shape the Internet Software & Services Industry are industry rivalry, new entrants, threat of substitutes, and consumers. In terms of industry rivalry, there is substantial competition for online ads spaces.. In terms of new entrants, it tends to take more time for newer companies to thrive within the industry. Usually, these companies need more money as early investments. However, once new companies enter the market, they can make a profit if they are able to create their own recognizable brand and find a way to differentiate themselves from their competitors. In terms of threat of substitutes, it isn't as large of a force that is shaping the industry due to familiarity and trust issues for consumers (Kessler). Switching over to different software and services offers a larger challenge to consumers due to these factors. Therefore, we believe that Facebook will be able to stay in a monopoly position for Social Media for the next few years. However, we also find that teenagers could also start to use other applications besides Facebook. For instance, Snapchat is a company that was able to quickly become part of the industry Source: Facebook 10k Facebook Users (in Millions) However, teenage consumers seem to be more drawn to newer apps, such as Snapchat and Instagram. Therefore, the future of companies within the industry will depend on whether or not they are able to retain and attract younger users to their products. The best positioned firms within the industry are Alphabet and Facebook. These larger firms are best positioned because their brand is more widely recognized, their user bases are larger than their competitors, they have more diversified and successful business models, and they have greater financial flexibility due to larger amounts of capital. The leaders within the industry are Alphabet and Facebook while the followers are Yahoo!, Twitter, LinkedIn, and other companies Total Facebook Users (in Millions) Important disclaimer appears on the last page of this report 6

7 Table Comparing Leading Competitors: GOOG YHOO FB TWTR LNKD Industry Market B B 13.49B M Cap: B 2B Employees 61,814 10,700 12,69 4,200 N/A 387 : 1 Qtrly Rev Growth Rev. (ttm): 74.99B 4.97B B 2.99B M B Rev. 34.8B 3.98B 8.51B 1.44B 1.85B N/A within USA Rev. 40.1B 0.99B B 1.14B N/A outside USA Rev. with 46.4% 80.1% % 61.87% N/A the USA% % Rev. 53.6% 19.9% % 38.13% N/A outside of the USA % % Gross Margin (ttm): EBITDA 24.42B B M (ttm): M M M Oper. Margin (ttm): Net Income (ttm): 16.35B -4.36B 3.67B M M N/A EPS (ttm): N/A P/E (ttm): N/A 77.2 N/A N/A PEG (5 yr expected): P/S (ttm): User base 1.80 B 0.8B 1.6 B 320M 414M N/A Users in 0.21 B N/A 0.22B 65 M 125M N/A the USA Users outside of USA 1.59B N/A 1.38B 255 M 289 N/A Users in the USA% Users outside of USA% Money spending on Research ( in Millions) Portion of spending on Research 11.67% N/A % 88.33% N/A % 20.3% 30.19% N/A 79.7% 69.81% N/A 12,282 1,178 2, N/A 16.3% 24% 27% 36.38% 25.95% N/A Banned by China, N Korea, Cuba, and some Arab nations None Bangl adesh, China, Iran, N Korea and Syria China, N Korea, and some Arab nations Sources: Digital Trends, Statista, Yahoo! Finance None N/A The key takeaways from this table are that Facebook and Alphabet are the leading competitors. They are in a positive life cycle. They are the most profitable and have the largest user bases. They also use their profits to do research & development and attract intelligent and skilled people to join their companies. Furthermore, more intelligent and skilled workers mean that Facebook and Alphabet are more likely to invent new, innovative products and attract more consumers, users, and investments. Finally, they have more revenue and net income than other competitors within the industry. More popular products may be invented More users More customers A Leading Position Almost every company spends a lot of money on research and development, even those that aren t in a good financial situation. Generally, the spending on research and development is the largest or the second largest part of spending, even more than cost of goods sold. This means that these companies believe that research is the future. For example, Twitter and LinkedIn have a poor financial situation, but they still spend large portion of budget on research because they believe new, innovative products will help them to get out of their poor financial situation. In addition, companies in this industry are very international. For example, for Alphabet, Facebook, or Twitter, over 70% of their users come from outside of the United States. This means that those companies are more likely to be impacted from international situations. For example, the appreciation of the US dollar has decreased about 6.25% of Alphabet s total revenue. Meanwhile, we find that these companies, which are successful in the industry, always have more international revenue than domestic revenue, such as Facebook and Alphabet. Therefore, whether companies can generate enough revenue internationally is a critical for companies' development. Catalysts for Growth/Change Positive Revenue and Net income More Users and bettter reputation More intelligent people will join the companies Higher efficiency and new ideas One factor driving the Internet Software & Services Industry going forward is that the number of people using mobile devices will continue to increase over the next few years. We believe this means there is potential for companies to capitalize off this and implement more mobile advertising to earn more profits from the increase in these numbers. Another factor that will drive the industry going forward is the amount of time people Important disclaimer appears on the last page of this report 7 More avaiable money to spend on research Providing better wages and Salaries

8 spend online. We believe that people will continue to spend more time online as technology continues to become more and more advanced, which will lead to more advertising revenue and lead to more growth within the industry. Source: Statista Key Investment Positives or Negatives We believe that a key investment positive for the Internet Software & Services Industry is that that companies market capital has been increasing in the past 5-8 years and we believe it will only continue to grow as this is a brand new industry and has great potential for growth. We also believe that another key invest positive is that the number of Internet users will continue to increase, making the market itself larger in the process Time Spent on Media (in Minutes per Day) TV Tablet PC Smartphone Raido Nespaper TV Tablet PC Smartphone Raido Nespaper Total Internet Users (in Millions) Number of Users Linear (Number of Users) frequently, which helps successful companies within the industry continue to be successful, innovative, and profitable, which makes their shareholders happy. We believe that a key investment negative for the Internet Software & Services Industry is that if you are looking to invest in a smaller company, you will have to be patient for a return on your investment because while smaller companies have the opportunity to generate positive income and see growth, it usually takes a while for this to happen. We also believe that another key investment negative for this industry is that technology is changing rapidly, so a product that helps to make a company successful and profitable today could be obsolete a few years down the line and cause the company to incur losses rather than generate profits. COMPANY-SPECIFIC ANALYSIS General Information Facebook builds useful and engaging products that enable people to connect and share through mobile devices and personal computers. They also help people discover and learn about what is going on in the world around them, enable people to share their opinions, ideas, photos and videos, and other activities with audiences ranging from their closest friends to the public at large, and stay connected everywhere by accessing their products, including Facebook, Instagram, Messenger, WhatsApp, and Oculus (10k). Corporate Strategy The mission of Facebook is to give people the power to share and make the world more open and connected. In order to give its users the power to share and be more connected with one another, Facebook has made mergers and acquisitions a significant part of its corporate strategy. Facebook aims to make acquisitions that will increase their specialized employees and complementary, products, and technologies. Because 92% of Facebook s total revenues comes from advertising, another part of its corporate strategy is to implement strategies to increase its total user base so that they can continue to increase their advertising revenue and overall company profits. Life Cycle It is difficult to determine the life cycle of a technology company that relies on social media because social media is such a new industry. There aren't many patterns to follow. However, we believe Facebook is more than likely in its growth phase as we are still seeing large increases in revenue, net income, and total user base. For example, revenue and net income has increased 100% since Also, Facebook s monthly active users have increased 50% since (10k) Source: Statista We also believe that another key investment positive for the industry is that highly-skilled workers tend to be hired Important disclaimer appears on the last page of this report 8

9 Net Income Compared to Revenue Revenue (in Millions $) 0 Net Income(in Millions $) Revenue (in Millions $) Net Income(in Millions $) Monthly Active Users (in millions) increasing expenses for research and development should only benefit the company has it produces new, innovative products to attract more consumers % 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Source: 10k Expenses (% of Total Revenues) 23.17% 10.46% Products and Markets 26.80% 27.49% 23.82% 17.98% 21.39% 17.27% 15.99% Cost of Revenue Research and Development 26.86% The product line of Facebook includes Facebook, Instagram, Messenger, WhatsApp, and Oculus. Facebook is the same-name social media network, Instagram is a photo-sharing social media network, Messenger is an app used to message others through Wi- Fi connectivity, WhatsApp is a cross-platform mobile messaging app, and Oculus produces virtual reality hardware for video game consoles. Facebook was founded in 2004, created Messenger in 2011, purchased Instagram in 2012, and purchased WhatsApp and Oculus in E Monthly Active Users Linear (Monthly Active Users) Source: 10k Financial Summary (for Fiscal Year 2015) The revenue and net income for Facebook has continuously been positive and growing since 2012, thus showing that Facebook has been in a healthy financial situation since then and we believe it will continue to be in one. Facebook s spending on research and development, 26.86% of total revenue, is the company s largest expense. This portion of spending on research and development has been increasing since The second largest expense of Facebook is cost of revenue, which represents 15.99% of total revenue. The cost of revenue has been decreasing since Therefore, we believe that with the development of newer, efficient technology, the cost of revenue will continue to decrease. Source: Statista Number of Users for Each Facebook Product (in Millions) Facebook Whatsapp Messenger Instagram Oculus The large amounts of expenses for research and development show that Facebook focuses its efforts on improving its current products and developing new ones for its consumers when other expenses keep at the same level. We believe that as long as Facebook is able to continually decrease its cost of revenue, its Among all products, Facebook, the social network, has the highest number of users in Facebook s total user base. However, the majority of Facebook s users are over 35 years old. Therefore, Facebook might have trouble retaining its future younger users. Important disclaimer appears on the last page of this report 9

10 We believe that Facebook has realized this and have taken steps to retain its younger users in other ways. For example, they purchased Instagram and WhatsApp, whose consumers are primarily younger people, which allows them to increase the total number of younger people in their user base. Demographic of Facebook Users' Ages use the products. Facebook also invests in marketing strategies that promote their products and services in an attempt to build their brand, grow their user base, and increase total user engagement. Total Revenues (In Millions) 849 Facebook Whatsapp Instagram Source: 10k Mobile devices and personal computers are the product markets for Facebook. We believe Facebook has a huge potential in these markets because even though cost per click will decrease over time, the number of smartphone and internet users will continue to grow in next five years, allowing to Facebook to capitalize off this in terms of advertising. We are able to reach this conclusion from historical records and the growth of total population. The increasing number of people who use smart phones will benefit Facebook and allow them to earn more revenue and profits as more and more people gain access to its products. (emarketer and AP) Source: 10k Marketing Strategy 0% 20% 40% 60% 80% 100% Internet Users (in Millions) Users numbers Linear (Users numbers) Facebook is able to increase its user base organically as its users invite their friends and family to connect with them via Facebook s products, thus increasing the number of people who Source: 10k Advertising The significant customers of Facebook are companies who are looking to advertise on one of Facebook s products. Facebook generates a substantial portion of its total revenue from selling advertising placements to these companies looking to advertise. Over 92% of revenue comes from advertising. Since 2011, Facebook s total revenue has increased over 20% every year since then. We believe this pattern will probably maintain for at least 3-5 years as more and more people utilize the internet as a tool to conduct business. Analysis of Recent Earnings Releases On January 27 th, Facebook released their earnings per share for The consensus forecast was $0.50 per share and they generated $0.59 per share. They were able to beat expectations by over 18% and, as a result, their stock price increased by about 14% within one day. We believe that Facebook beating the expectations for their total revenue is the reason their stock price continues to increase. In the future, we expect Facebook s stock price to continue to increase due to the increasing numbers of their user base and more companies start to use Facebook as a platform to do advertisements. We also believe that Facebook s user base will be positively driven by the increasing number of smart phone users. In particular, Asia would be a huge potential market for Facebook since the American market is close to being saturated. The United Sates & Canada currently have over 219 million Facebook users with a total combined population of about 350 million people. Asia, however, has a larger population than the US that has a large appetite for technologies. Facebook s increasing user base will attract more companies to use Facebook as an advertising tool to be able to reach out to potential customers within Facebook s increasing user base. Production and Distribution The Internet is the distribution channel for Facebook. Laptops, mobile phones, and tablets are the primary tools that people use to access Facebook and its other products. People who have Important disclaimer appears on the last page of this report 10 Payments and other

11 accounts for Facebook and its other products are the suppliers of Facebook. The more people that use Facebook, the more incentive companies will have to pay money to Facebook to do advertise. Competition Facebook faces significant competition in every aspect of their business, including from companies that provide tools to facilitate communications and the sharing of information, companies that enable marketers to display advertising, and companies that provide development platforms for application developers. The direct competitors of Facebook include Twitter, Alphabet, LinkedIn, and Yahoo! All of these competitors are trying to increase their user bases in an attempt to compete directly with Facebook s large user base. Comparative Analysis GOOG Market Cap: Employe es: Qtrly Rev Growth Rev. (ttm): Rev. within USA Rev. outside USA Rev. within USA% Rev. outside of USA % Gross Margin (ttm): EBITDA (ttm): Oper. Margin (ttm): Net Income (ttm): EPS (ttm): P/E (ttm): PEG: 5yr expected YHO O B B FB TWTR LNKD B 9.95B 13.49B 61,814 10,700 12,691 4,200 N/A 18% 2% 52% 58% 34% 74.99B 4.97B 17.93B 2.22B 2.99B 34.8B 3.98B 8.51B 1.44B 1.85B 40.1B 0.99B B 1.14B 46.4% 80.1% 47.46% 64.86% 61.87% 53.6% 19.9% 52.54% 35.14% 38.13% B M 8.24B M M B -4.36B 3.67B M M N/A 77.2 N/A N/A P/S (ttm): User base Users in the USA Users outside of USA Users in the USA% Users outside of USA% Mobile Users Mobile Users% Money spending on R&D (in Millions) Portion of spending on R&D Banned in Source: 10Ks Important disclaimer appears on the last page of this report B 0.8B 1.6 B 320M 414M 0.21 B N/A 0.22B 65 M 125M 1.59B N/A 1.38B 255 M 289M 11.67% N/A 13.75% 20.3% % 88.33% N/A 86.25% 79.7% % N/A 0.8 B 1,442B 256M 53m N/A 75% 90.12% 80% 12.8% 12,282 1,178 2, % 24% 27% 36.38% % China, N Korea, Cuba, and some Arab countries None Banglad esh, China, Iran, N Korea and Syria China, N Korea, and some Arab countries None Compared to its competitors, Facebook is the leading company. One reason for this is because Facebook created its business before some its competitors, cultivating a huge user base which has grown to be five times larger than that of Twitter, LinkedIn and Yahoo. Advertising companies will want to pick a social media company to advertise through in order to reach the largest numbers of people, so this puts Facebook at a large advantage over its competitors. Facebook s large user base has allowed it to attract investments from companies looking to advertise. In addition, more investments from these companies means that Facebook can spend more money on research and development to develop new and innovative products to attract new consumers and continue to increase its user base. Finally, Facebook will receive more investments. When some potential competitors emerge that are complementary to Facebook and can provide some benefit to the company, Facebook can use its cash and shares to acquire those companies, such as it did with WhatsApp and Instagram. By acquiring these emerging companies, Facebook can secure its leading position and continue to innovate.

12 Compared to other social media companies, Facebook is the most international company of them all. More than 50% of Facebook s total revenues come from operations outside of the United States. More than 85% of its users live outside of the United States. We believe this will show that Facebook has more international reputation, meaning that Facebook could attract more potential customers from Europe and Asia in the future. Also, large abroad user base could bring international advertisement companies investment to In addition, Facebook has a dominant position in the mobile phone area. For example, 90.12% Facebook users use the mobile as a channel to look up information, which is the highest one among its competitors. We believe people will use mobile phone more often in the next decade. Facebook could use mobile users to attract advertisements companies Source: Statista Numbers of mobile users (In millions) Numbers of Users (In millions) Linear (Numbers of Users (In millions)) However, we believe that Facebook is facing challenges from a different area. For example, even though Facebook has the largest user base of all social media companies, younger people tend to want to use Snapchat or Twitter, rather than Facebook. Therefore, Facebook will have to make some changes and implement new products and services that can attract younger users. Facebook Source: Business Insider Other Topics R&D Twitter LinkedIn Instagram Snapchat Research and development costs for Facebook consists primarily of share-based compensation, salaries, and benefits for employees within their engineering and technical teams working on building new products and improving existing products. R&D is the largest cost within the Costs and Expenses section of the Facebook s 2015 Income Statement, being $4.816 Billion. This shows that Facebook is willing to invest heavily into maintaining their current products and invest in new ones, such as connectivity efforts, artificial intelligence research, and virtual reality (10k). Foreign Sales Demographic of Users' Ages for the Top Social Media Companies 0% 20% 40% 60% 80% 100% Because Facebook is a social network that is used globally, they often generate revenues and profits in currencies other than the USD. This means that Facebook is susceptible to Foreign Currency Risks. Recently, in 2015, Facebook experienced foreign currency exchange losses of $66 million, which was down from the $87 million loss the company incurred in Government Regulation Facebook is subject to a number of US Federal, State, and foreign laws & regulations affecting many similar businesses on the Internet. Notably, Facebook is primarily subject to laws involving foreign data protection, privacy, and other restrictions that can be more restrictive in foreign countries than those in the US (10k). Composition of Board of Directors Mark Zuckerberg is the founder, Chairman, and CEO of Facebook. He is in charge of providing the overall direction and product strategy for the company. He also leads the design of Facebook s service and development of its core technology and infrastructure (Facebook). Important disclaimer appears on the last page of this report 12

13 Major Stockholders Within Facebook, Mark Zuckerberg only owns 20% of total stock. However, Facebook is structured in a way that makes it a dual class company. Zuckerberg owns about 20% of the company, but almost all of his stock is class B stock, which gets ten votes for every one vote given to regular class A stock. Therefore, Mark Zuckerberg has a superior control over the company, being the largest voting power. Almost all other majority shareholders are passive hedge funds. These other majority shareholders being passive helps to strengthen the control rights of Mark Zuckerberg. Payout Policy Facebook has never declared or paid cash dividends on their stock, nor do they intend to do so within the foreseeable future. Instead, Facebook invests retained earnings back into the company itself and uses their earnings to finance current and future operations and expand their business (10K). Catalysts for Growth/Change One catalyst for growth and change for Facebook is its growing user base, which means that Facebook has the opportunity to capitalize off this and increase their total revenues. Another catalyst for change and growth for Facebook is their large market capital, which allows them to be able to acquire other companies and technologies which will complement and benefit Facebook. Another catalyst for growth and change for Facebook is the fact that it has been investing a lot into research & development, which allows them to be able to maintain their current products and invest in newer, innovative products which will attract new users. Key Investment Positives/Negatives (S.W.O.T. Analysis) Strengths Facebook s growing user base helps to contribute to its increasing average revenue per user as its total revenues also continue to increase. The growing user engagement for the consumers of Facebook s products increases appeal for advertisers and makes them want to purchase more ad space. Facebook s lucrative user base will provide value for companies and developers looking to advertise through Facebook s products as Facebook has the largest user base among all social media companies. Weaknesses Facebook has a high dependency on advertising revenues, as it makes up 92% of its total revenues, which puts Facebook at significant risk because should something happen to the company which negatively impacts its advertising revenues, Facebook could incur heavy losses. Facebook is still currently in its growth phase, so the historical growth figures that it has had will be close to impossible to maintain as it reaches its maturity phase over time. Even though Facebook bought Instagram and WhatsApp to bring younger users into its user base, we do not believe that Facebook will be able to maintain its 70% market share due to fierce competition. Over 85% of Facebook's users are from outside of the United States, but only 53% of its revenue comes from outside of the US. We have doubts that Facebook will be able to convert their user base into actual revenue outside of the US. If Facebook cannot successfully do this, then their revenue growth rate will be negatively affected. Opportunities There has been strong growth in overall US digital display advertisement spending which means that Facebook could see an increase in companies looking to purchase ad space through their products. There has been growth in overall mobile advertising worldwide, which means that Facebook could capitalize off this through ad spaces on their products. New product offerings by Facebook, such as the recent release of the Oculus Rift, will provide some revenue diversification and help Facebook decrease the risk that is involved in advertising revenue making up such a significant portion of their total revenues. Threats Facebook is always facing intense competition as the Internet Software & Services Industry is one of the most competitive environments in which to operate. Facebook operates within a stringent regulatory environment which could deter them from implementing strategies that may benefit the company, but aren t allowed to due to regulations. In an age where cyber-crime has been increasing, Facebook faces the threat of potential security breaches which may negatively impact the overall reputation and business of the company (MarketLine). VALUATION DISCUSSION Revenue Decomposition To forecast Facebook s future revenue. We first looked at Facebook s historical revenue. We noticed that they had increasing revenue along with an increasing user base. Therefore, we divided revenue by users to get revenue per users. Then, we used the user base and revenue per users as our standards to forecast revenue. Important disclaimer appears on the last page of this report 13

14 Right now, we believe that the ceiling of total Facebook users is 2 billion users since the world Internet users is 3 billion and over 600 million Chinese potential users are not allowed to use Facebook within China. However, as time goes by, we believe that Internet users will increase to about 4 billion with the increase of accessibility of the Internet in developing countries and the growth of the overall population of the word. Also, with globalization, China will eventually open to Facebook in the next few decades. Therefore, we predict that Facebook users will grow to about 3 billion in The revenue per users will continue to grow since more and more people start to use social media as a tool to do advertisements. However, the growth rate will not remain at 30% every year. We believe the growth rate will gradually go down smoothly over the next 10 years. If we combine those two factors together, we believe that the revenue of Facebook will go up, but the growth rate will go down over the next decade. Cost of Goods Sold Although Facebook's revenue has been increasing, we actually noticed that the the cost of goods sold has been decreasing since This is mainly because the main channel of Facebook is internet which is almost free for Facebook to use. Therefore, Facebook does not have to spend money on depreciation and amortization and other tangible goods. Meanwhile, with the development of newer technology, the cost of materials is going down. For example, the price of fiber optics have going down over the past century. Therefore, we believe the cost of goods sold will continue to go down in the next ten years until reach to a low level. Research and Development The cost of research and development is the biggest cost for Facebook, and it has been going up since As a social media company, it is very important for Facebook to invent popular products in order to attract and retain users. In the Internet Software & Service Industry, almost every company spends more than 20% of their total revenue doing research and development. Therefore, we believe that Facebook will continue to invest money in doing research. And cost of research and development will remain as Facebook's largest cost. Discounted Cash Flow and EP Model Dividend Discounted Model We do not think Dividend Discounted model will work accurately for Facebook since Facebook never pays dividends. We also believe Facebook might never pay dividends since Mark Zuckerberg says he will not pay dividends to investors, but rather take the earnings and invest it back into the company itself. Relative Valuation Model We choose to compare Facebook with its direct and indirect competitors to see how the company is valued relative to other companies which are in the same industry. To look at value of Facebook, we used P/E for 2016 and 2017 of our comparison companies. The comparison of the companies includes the biggest company of the industry, old companies, and new companies. Therefore, our evaluation is very comprehensive. Our relative P/E in 2016 shows that the industry average price is 21.6, which is not very helpful to forecast since Facebook has a dominant position in the social media area. Therefore, people might only invest in Facebook. However, for PEG ratio, the forecast price matches with what we have. Weighted Average Cost of Capital We calculated Facebook's WACC to be 7.08%. Our WACC estimate included total equity and operating leases. Total equity has over 99.5% weighted average, which makes WACC and Cost of Equity very close. Beta We got a one-year average raw beta from Bloomberg of Cost of Equity In order to calculate the Cost of Equity for Facebook, we got the raw beta from Bloomberg, which is Then, we used the current 30-year Treasury Yield as the risk free rate and used the market return and historical 30-year Treasury Yield as the risk premium which is 4.57%. Finally, we multiplied the risk premium times the raw beta plus risk free rate. The final value of our Cost of Equity is Cost of Debt Our Discounted Cash Flow analysis and Economic Profit model both indicated that the intrinsic stock price is $ We changed this value to reflect that some of 2016 has been passed. As 04/19/2016, Facebook s stock price was The current stock price over our prediction over 80.17%. We believe that those difference actually comes from the estimation of future growth rate. We believe that the revenue growth will gradually go down in the next ten years. Facebook does not have much debt. Due to high gross profit, they store lots of cash in their company. The only debt Facebook has is for its operating leases. Since Facebook does not issue any bonds, we had to look at similar company, like Apple, as a reference. We used a 30- year corporate bonds since it represented the longest period of Apple's corporate bonds. Important disclaimer appears on the last page of this report 14

15 SENSITIVITY ANALYSIS Our evaluation models are based on the assumptions which we believe are highly volatile. We wanted to find a range of data for our future stock price when some variables change. In addition, we wanted to look at how sensitive some of our factors are. WACC has a huge impact on our stock price. Therefore, if interest raises in the future, the WACC will go up, and our stock price will go down. WACC to ROIC When WACC is held constant, our stock price goes up a little bit when ROIC goes up. The range is from to When ROIC is held constant, our stock price goes down with the increase of WACC. The range is from to Therefore, our stock price is not very sensitive to change with the change in ROIC. On the other hand, our future price will be largely influenced by the interest rate. Equity Risk Premium to Beta When Beta is held constant, our stock price varied from to When Risk Premium is held constant, our stock price decreased as beta increased, from to We believe that Facebook has outperformed than the S&P. The more similar Facebook is to the market, the lower Facebook's price will go. Cost of Debt to Marginal Tax Rate When Cost of Debt is held constant, our stock price only made a little change with the changes of Marginal tax rate. We believe our stock price is not sensitive to the tax since over 99% of the moving average weighted debt is equity. No matter how the marginal tax rates change, our stock price generally stays a constant level as long as Facebook doesn't have much debt. CV Growth to WACC When CV Growth is held constant, the stock price will become lower with the increasing value of WACC. The stock range changes from to Therefore, we think Important disclaimer appears on the last page of this report 15

16 IMPORTANT DISCLAIMER This report was created by students enrolled in the Applied Equity Valuation (FIN:4250:0001) class at The University of Iowa. The report was originally created to offer an internal investment recommendation for The University of Iowa Krause Fund and its advisory board. The report also provides potential employers and other interested parties an example of the students' skills, knowledge, and abilities. Members of the Krause Fund are not registered investment advisors, brokers, or officially licensed financial professionals. The investment advice contained in this report does not represent an offer or solicitation to buy or sell any of the securities mentioned. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, The University of Iowa, its faculty, staff, students, or the Krause Fund may hold a financial interest in the companies mentioned in this report. REFERENCES < ber-of-smartphone-users-worldwide/>. Facebook. Board of Directors. Feb < Kessler, Scott. Industry Surveys: Internet Software & Services. New York: S&P Capital IQ, MarketLine. "Facebook, Inc." 28 January Marketline, Advantage. < FB C F9D5BEF4>. S&P Capital IQ. "NetAdvantage." 17 Feb Facebook Inc Cl'A'. < m/nasapp/netadvantage/simplesearchrun.do?c ontrolname=homepagesearch>. Statista. Number of monthly active Instagram users < ber-of-monthly-active-instagram-users/>. 10K, Facebook. FACEBOOK INC. MENLO PARK, CA 94025: Facebook, < NJ5DZ/ x0xS / /filing.pdf>. Analysts, Thomson One. Thomson One. 16 Feb < n.aspx?view=action%3dopen&brandname= BBC. Google services set for 'return' to China. N/A: BBC News, CNBC. "Facebook buying virtual reality firm Oculus for $2 billion." Tuesday Mar CNBC. < buying-virtual-reality-firm-oculus-for-2- billion.html>. Cordray, Robert. Net Neutrality's Effect on Advertising. N/A: Digitalist Magazine, emarketer and AP. "Number of smartphone users* worldwide from 2014 to 2019 (in millions)." Feb statistics. FACEBOOK, INC. (2016, 1 29). Retrieved from EDGAR Company Filings: search.html Alphabet Inc. (2016, 2 11). Retrieved from EDGAR Company Filings: 6/ /goog10-k2015.htm LinkedIn Corporation. (2016, 2 12). Retrieved from EDGAR Company Filings: 4/ /a xkdocument.htm Number of mobile monthly active Facebook users worldwide from 1st quarter 2009 to 4th quarter 2015 (in millions). (2016). Retrieved from Statista: er-of-mobile-active-facebook-users-worldwide/ Number of monthly active Facebook users worldwide as of 4th quarter 2015 (in millions). (2016). Retrieved from Statista: Important disclaimer appears on the last page of this report 16

17 c=s&source=web&cd=4&cad=rja&uact=8&ved=0a hukewipoumd1zvmahujnomkhcmtbaoqfggsm AM&url=http%3A%2F%2Fwww.statista.com%2Fst atistics%2f264810%2fnumber-of-monthly-activefacebook-usersworldwide%2f&usg=afqjcng66i13xigo Number of monthly active WhatsApp users worldwide from April 2013 to February 2016 (in millions). (2016). Retrieved from Statista: er-of-monthly-active-whatsapp-users/ Patterson, M. (2015, May 4). Social Media Demographics to Inform a Better Segmentation Strategy. Retrieved from Sprout Social: The World Factbook. (2016). Retrieved from CENTRAL INTELLIGENCE AGENCY: Twitter, Inc. (2016, 2 29). Retrieved from EDGAR Company Filings: 1/ /twtr-10k_ htm Yahoo! Inc. (2016, 2 29). Retrieved from EDGAR Company Filings: pany Important disclaimer appears on the last page of this report 17

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